It works best when you start early
One in four 401(k) savers increased their contributions last year. This additional saving will translate into hundreds or even thousands of extra dollars of monthly income in retirement, according to calculations from Fidelity Investments. All of which highlights the value of the automatic savings increases that are offered by many, but not most, retirement plans.
Financial planners typically advise saving 15% of pay starting early in your career. If you do this, you have a good shot at retiring comfortably in your mid- to late 60s. But 15% may be a high bar, especially for young people saddled with student debt and the costs of setting up a household. In that case, planners suggest starting with a more modest goal and building over time.
Your minimum contribution should be an amount that earns the full company match, probably around 6% of pay. Shoot for 10% if you can. In any case, the idea is to get to 15% by raising your contributions by 1% of pay every year until you have hit that level. This may mean dedicating much of your annual pay increases. But the payoff is significantly higher income later on.
Consider a 25-year-old earning $40,000 a year and receiving an annual pay hike equal to 1.5% more than the rate of inflation. If this person raises their contribution rate by 1% of pay now—$33 a month—it will generate $190 of additional monthly income between ages 67 and 93, Fidelity reports. This assumes average annual returns of 3% above the inflation rate.
That may not sound like a lot. But it’s the fruit of just a single 1% bump in your contribution rate. Say you raise the rate by 1% every five years. That buys you $690 of additional monthly retirement income. If you stick to the plan for 12 years—raising your contributions by 1% each year through age 37—you will enjoy $1,930 of additional monthly retirement income.
These small savings increases have the biggest impact on millennials, who have decades for their money to grow. But even those who have reached mid-career and are making more money still have much to gain from 1% saving boosts. Earlier research from Fidelity found that a 45-year-old earning $70,000 a year who hiked 401(k) contributions by 1% just once would end up with an additional $157 of monthly income in retirement.
Perhaps the most valuable aspect of the Fidelity research is the focus on retirement income, rather than size of your nest egg. During the first 30 years of the 401(k) industry, workers were mostly advised to build a six- or-seven-figure portfolio. But as baby boomers started to retire and have begun tapping their savings, the task of generating retirement income has moved front and center. With low interest rates, it’s not so easy to turn that portfolio into a steady income stream, so it’s crucial to figure out how to make your money last in retirement.
The giant asset manager Blackrock has its Cori tool, which illustrates how much guaranteed lifetime income you could buy with your savings after age 55. But most financial firms speak in terms of how long your nest egg will last if drawn down at a consistent rate each year, adjusted for inflation. They assume you will live 25 to 30 years after retiring, and they shoot for a withdrawal rate of around 4% that gives you a high probability of not outliving your money.
This is an uncertain approach, given unknown advances in medicine that could extend your years beyond current expectations. So saving a little more now—just 1% more a year for the next five or 10 years—may be just the insurance policy you need. If your 401(k) doesn’t offer an automatic escalation feature, set a reminder on your calendar and raise the amount yourself.